Voluntary Assurance on Interim Financial Statements and Earnings Quality

Abstract

Under current Canadian securities regulatory requirements, public companies are able to choose whether to have their interim financial statements reviewed by external auditors on a quarter by quarter basis, but they must disclose when there has been no review performed. This differs from US practice where the Securities and Exchange Commission (SEC) requires a timely review of interim financial statements by the company's auditor. In the context of a global trend towards harmonization of accounting, auditing and securities regulations, various jurisdictions around the world, including Canada, are contemplating the adoption of the mandatory review practices followed in the US. Opponents of the mandatory review approach argue that were such practices adopted, then a signalling opportunity for companies with higher quality earnings would be lost.

Since all US companies must have a timely review there is little opportunity for companies to signal their quarterly earnings quality and thereby differentiate themselves. Thus, the Canadian regulatory environment provides a natural laboratory to study the association between the determinants of voluntary reviews and earnings quality. Our study seeks to contribute to this debate by investigating the relationship between voluntary assurance on interim financial statements and earnings quality, as measured by the volatility of the accruals reported in those statements. We hypothesize and find evidence that the voluntary choice mechanism permits Canadian firms to signal high quality quarterly earnings. Consistent with Larcker and Richardson (2004), earnings quality is measured as the magnitude of discretionary accruals. Firms with lower earnings quality contemplating a review would likely be dissuaded from making this choice to avoid questions and challenges from their auditors about their high discretionary accruals.

Our results provide evidence that the voluntary review engagement has value as a signalling mechanism. Thus, there are benefits to keeping auditor reviews of interim financial statements voluntary. This suggests that regulators who are considering adopting mandatory review as in the case of US domestic firms should proceed carefully so as not to lose the signalling benefits associated with voluntary reviews.

Keywords: voluntary review, voluntary reporting, interim reporting, accruals

JEL Classification: M41, M43, M47, M49, G38